Research

Derivatives and Hedging: Speculation Tools or Effective Risk Management in a Volatile Market?

Derivatives and hedging are tools that remain necessities in the financial system as a way to manage risks that might arise from uncertainties and price fluctuations in the market, although it remains a contentious subject in Islamic finance due to some of the features in the instruments that invite speculative trading. Views are often split from a Shariah standpoint, given that excessive uncertainty and speculation are concepts not permissible in Shariah compliant transactions. Danial Idraki writes.

Overview

The presence of a variety of risks in the financial system, such as those embedded in foreign exchange rates, equities, interest rates and commodity prices, requires the need for hedging to avoid unwanted losses. Hedging, as a method to safeguard or minimise losses from risks involved, utilises derivative instruments, such as forwards, futures, options and swaps. Shariah scholars contest the permissibility of derivatives as they are often viewed as something that leads to excessive risk due to uncertainty (Gharar) and speculation (Maisir), which raises the issue of its validity when it comes to Islamic finance. As such, the fundamental purpose of hedging to manage risk is one that is still up for debate in the Shariah world.

However, with the exponential growth of Islamic finance over the years and increasing cross-border activities, it is difficult to avoid certain transactions from being exposed to fluctuations. Islamic banks and financial institutions have the responsibility to effectively manage risk as they are answerable to stakeholders that have tasked them with managing its finances. With a growing number of firms tapping the Islamic capital markets to source for financing, especially in Muslim-majority countries where the marketplace is increasingly demanding for Shariah compliant products, the lack of instruments for hedging risk hinders the robust growth of the Islamic finance industry.

The need for effective hedging tools is even more timely as Islamic finance is not entirely insulated from the volatility in the market, as exemplified by the turbulent 2015 with plunging oil prices and uncertainty over the US Federal Reserve interest rates that affected Islamic banks globally. While the lack of exposure to derivatives during the 2008 global financial crisis may have been attributed by market players as one of the reasons why Islamic banks performed better than their conventional counterparts, the market is seeing more volatile activities and it will not always remain the case that Islamic finance will outperform their conventional peers during times of great uncertainty.

Industry initiatives

In November last year, the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) published the Islamic Cross-Currency Swap (ICRCS), or known in Arabic as ‘Himaayah Min Taqallub As’aar Assarf’, for use in Islamic hedging transactions. The published confirmation template is part of an ISDA and IIFM plan to provide the Islamic finance industry with documentation and product templates to manage risk in transactions arising mainly from currency and profit rate mismatches. The ICRCS template falls under the ISDA/ IIFM Tahawwut (Hedging) Master Agreement, a framework document that contains general terms and conditions, and early termination and close-out netting provisions between transacting parties. The Bahrain-based IIFM is also currently developing an Islamic foreign exchange forward (‘Wiqayah Min Taqallub As’aar Assarf’), which is yet to be published.

The Indonesian central bank, Bank Indonesia, had in March this year issued Shariah hedging instruments (under regulation 18/2/PBI/2016) aimed at providing the option of Shariah schemes in mitigating the risk of exchange rate volatility. The new regulation is based on the principle of Muwaada, in which two parties agree to a future transaction at a spot rate, and Bank Indonesia allows both Islamic and conventional banks to offer deferred sales of foreign exchange through the Shariah-based forward agreement, and prohibits transactions with speculative objectives.

Bank Maybank Syariah was also reported to be preparing Shariah hedging products and is looking at offering them this year. The bank’s US dollar portion financing makes up around 30-40% of total financing, according to the bank’s head of product development and strategy, Habibullah, as quoted by Republika.co.id.

Earlier in January, it was reported that Iran’s Securities and Exchange Organization (SEO) defined rial-denominated bonds as the basis for transactions in the soon-to-be-launched foreign exchange derivatives market, according to the head of SEO, Muhammad Fetanat. Five Islamic scholars in the Islamic Jurisprudence Committee in the SEO will supervise the compliance of capital market instruments with Islamic principles in both the Sukuk and foreign exchange derivatives markets, according to a report by Financial Tribune.

Conclusion

While there already exists a number of Shariah compliant financing structures in the forms of derivatives, such as Salam contracts, Murabahah-based profit rate swaps, Waad contracts, dual currency Murabahah and Islamic cross-currency swaps, among others, the sole objective of hedging in Islamic finance is to manage risk and not as a form of profiteering, with real economic activities taking place.

 

This article first appeared in Islamic Finance News (27 April 2016, Volume 13, Issue 17, Page 14). For more information, please visit the website at www.islamicfinancenews.com.

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